When you buy real estate, the assessed valued is divided between the land and any improvements; improvements can include everything from houses and other structures to landscaping and septic systems, basically anything that isn’t bare land. Figuring out how best to divide the value between land and improvements is as much an art as it is a science, and sometimes it is in your best interest as a property owner not to accept the original allocation.
This is especially true for income property. Land is not depreciable, and depreciation can have a significant impact on your taxable income. Here’s how it works. When you purchase a rental property, the county assessor determines the land/improvement split. Ideally, the land value will be low, and the improvement value will be high. If the assessor says the land/improvement split is 40/60 but you’d rather it be 20/80, there are steps you can take to make that happen. Before I explain further, let’s discuss why this matters.
As you hold property, the value of improvements declines over time for tax purposes; this is called depreciation. It is a non-cash expense, which is the best kind when it comes to taxes. Non-cash expenses can be used as write-offs that do not require you to spend any money.
Say you bought a property for $700,000 and the assessor attributed 40 percent of the value to the land and 60 percent of the value to the improvements. The depreciable value of the purchase would be $420,000. The non-cash tax deduction is about $14,500 per year (the government mandates a 29-year depreciation period), saving you about $5,000 in taxes per year. Not bad. However, if you had a 20/80 split, you would now have $560,000 of value to depreciate. This equates to about $19,300 in write-offs or $6,500 in annual tax savings.
In fact, the tax benefits of deducting depreciation are two-fold. First, current deductions go against current ordinary income. Second, when you sell the property without reinvesting the earnings in a new property, the “recapture of depreciation” you must pay will be at a lower rate than ordinary income rates. I’m getting a little technical here, but the point is: the more depreciation, the better.
So how do you adjust the land/improvements split? The best way is to hire an appraiser to reassess the split. Keep that appraisal with your legal real estate documents in case the IRS ever comes auditing. To be extra safe, you can take the appraisal to the county assessor’s office and ask them to reallocate the assessment in line with the appraisal. Since it doesn’t cost the county anything in property taxes to adjust the split, they probably won’t put up much of a fuss.
If you purchase a business that includes real estate, consider negotiating the value of the land, improvements, and other business assets with the seller and then asking the escrow officer to itemize them on the closing statement. The same goes for purchasing a vacation home that is already furnished. Because it is in the seller’s interest to reduce the cost of improvements and the buyer’s best interest to increase the allocation of the cost of improvements, those itemized lists can carry a lot of weight with the IRS.
Although I have focused on income properties, this is good information for any homeowner. You don’t always know when you’re buying an income property; you may purchase a residence and eventually convert it to a rental. So, it is wise to pay attention to the land/improvement allocation. You can only adjust it when you first purchase the property.
Please note, I am not giving any tax advice here. My goal is to provide information for you to discuss with your tax accountant or legal counsel.
If you have questions about property management or real estate, please contact me at email@example.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery. To see previous articles, visit www.selzerrealty.com and click on “How’s the Market”.
Dick Selzer is a real estate broker who has been in the business for more than 45 years.